Surge and the rupee

Indian Express, 6 November 2007

The US Federal Reserve decided to cut interest rates once again in its meeting this week. Last month when the Fed cut rates, it led to a surge of capital flows into India. In the 6 weeks since the last Fed rate cut, portfolio investment of USD 8.7 billion flowed into the Indian stock market. A higher interest rate differential combined with India's growth story will mean that India will remain an attractive investment destination for global investors.

A major concern arising from the surge in capital flows is the pressure on the rupee to appreciate. There has been immense pressure on the government to keep the rupee cheap. The government has tried to do three things: buying dollars in the foreign exchange market, imposing restrictions on capital inflows and liberalising capital outflows. If we look on a day to day basis, it may seem that the policy has had some success, but a longer term perspective suggests that it may have actually exacerbated the problem of capital surge that we face today.

The last five years have seen a global decline of the dollar. Major currencies of countries where central banks do not trade in currency markets have shown an appreciation against the US dollar. The index of major currencies tracked by the US Federal Reserve shows that from mid April 2002 till date, there has been a 34 percent depreciation of the US dollar. Over this period the dollar has seen a comparable depreciation against the Indian rupee of 20 percent. However, the appreciation of the rupee has not been a normal market process. The rupee has rarely witnessed the two way movement on a day to day basis in the manner other currencies have. The appreciation of the rupee has been fought hard all the way by the RBI. As a result, there have been long periods when the rupee has appreciated slowly with the RBI actively intervening to prevent sharp movements.

This slow appreciation has been truncated by periods of sharp volatility when the RBI let go and the rupee saw sharp appreciation. These episodes of sharp appreciation have been painful and unpopular as the business sector was exposed to sudden destabilising shocks. After the sharp appreciation of the rupee in March-April this year, many exporters complained that what hurt them most was not the appreciation itself but the suddenness with which it came. On the whole we find that RBI's trading on the currency market has not prevented rupee appreciation. What it has given is painful lurches of the exchange rate, instead of a gradual process of adjustment based on ordinary market forces.

RBI's currency trading has also injected excess rupees in the system, leading to high consumer price inflation which is a major concern for the government. The rising fiscal costs of the "sterilisation" effort through the Monetary Stabilisation Scheme (MSS) that tries to pull out this liquidity is borne by the exchequer. RBI's exchange rate policy has impacted the budgets of households and businesses as the RBI has tried to cope with its liquidity injection through hiking cash reserve ratio of banks. There have been painful and unexpected hikes in interest rates on bank lending and home loan EMIs unpopular with both the vocal middle class and corporate India. Attempts at capital controls to curb inflows have created instability in stock markets. The most striking example of this was the latest attempt at restrictions on participatory notes.

An important side effect of the attempt to prevent rupee appreciation has been that it has made the rupee a one way bet. First, speculators see India's huge foreign exchange reserves and know that it is unlikely that the rupee is going to depreciate in any serious way. The sole purpose of the reserves is to defend the currency in case there is a pressure on the rupee to depreciate. Second, speculators see the huge pressure on the rupee to appreciate and the futile attempts by the RBI to prevent this appreciation.

When speculators see the difficulties policy makers are facing, they conclude that it is not possible to keep up the effort to prevent rupee appreciation for very long. A speculator who looks back sees that episodes of capital controls, or increased MSS limits, merely served as forecasts of future rupee appreciation. Not surprisingly, speculators know that either the rupee will stay where it is, or it will appreciate. In other words, the rupee is a one-way bet.

The belief that the rupee can move only in one direction is leading to large amounts of speculative capital coming into India. This is larger than what it would have been had the rupee moved both ways and witnessed genuine volatility as in the currencies where central banks do not intervene. The policy of RBI buying dollars might have been created to prevent rupee appreciation, but it is actually increasing the pressure on the rupee to appreciate. Critics of globalisation harp on unstable capital flows. But in this case, it is the policy mistakes of the government which are destabilising the capital flows.

The best way for India to respond to the surges in capital flows is to let the rupee be flexible. As a fast growing economy, India will continue to attract capital, but the short term speculative capital betting on rupee appreciation would be reduced. Further, concerns about job losses in export sectors such as automobile parts, textiles and leather could be addressed by giving direct compensation to workers in these sectors and meaningful retraining programmes. Not only would it prevent distorting the entire Indian economy to be geared towards the supplying the US consumer with cheap Indian goods, instead of focussing on the Indian consumer, even the costs of these programs would be lower than the fiscal cost of this policy today.

Actually, a stronger rupee would help some exporters to the extent of reducing the cost of imported goods. With reduced forex intervention sudden and sharp hikes in interest rates that affect everyone, including exporters, would be avoided. So even the impact on total exports may be less than what it may appear at first blush. A stronger rupee and a stop to the huge liquidity injection through forex intervention will pull down consumer price inflation. The US economy may continue to see turmoil for some time. We do not need to import its turmoil into India by pegging the rupee to the US dollar.